| Bond Bought at a Discount |
Determining the cost basis of a bond
or note bought at a discount from
par value depends on two factors:
(1) whether it is TAXABLE or
TAX-EXEMPT, and
(2) whether you held it until the
maturity date or sold it prior to
maturity (or it was called.)
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For each combination of factors, the answer is detailed below. Page down until
you see your particular situation:
A. If you bought a TAXABLE bond at a DISCOUNT and redeemed it at MATURITY:
Your cost basis is par value, but to arrive at that result is a three-step process for
individual investors:
(1) Determine the original purchase price per bond from the trade confirmation.
Do not include the accrued interest that you may have paid at the purchase date.
You should have already deducted this on your Form 1040 Schedule B as a reduction
of interest income in the year of purchase.
(2) Add any OID (original issue discount) interest which has been taxed to you on
Form 1099 each year since you bought the bond. This is an increase in your cost
basis because you paid tax on interest income which you will not receive until
maturity.
(3) If the sum of steps (a) and (b) is less than par value, increase your cost basis
to par value by taking the remaining difference and reporting it as taxable interest
on your Form 1040 Schedule B in the year the bond matures. This difference repre-
sents the market discount which is really additional interest to you over the life of
the bond. It is not eligible for capital gains treatment and has to be reported as
ordinary taxable interest income.
B. If you bought a TAX-EXEMPT bond at a DISCOUNT and redeemed it at MATURITY:
Your adjusted cost basis is par value.
C. If you bought a TAXABLE bond at a DISCOUNT and sold it PRIOR to maturity:
There are two possible answers in this case. Examine the description of the
bond on your original trade confirmation or on your monthly brokerage
account statement. If the initials "OID" appear anywhere in the description,
the bond was issued with an original issue discount and you should determine
your cost basis by Method A. If not, it is a "market discount" bond, and you
should use Method B.
Method A. If the bond was issued with an original discount, first determine
the original purchase price per bond from the trade confirmation. Do not
include the accrued interest that you may have paid at the purchase date.
You should have already deducted this on your Form 1040 Schedule B as a
reduction of interest income.
Add any OID (original issue discount) interest which has been taxed to you on
Form 1099 each year since you bought the bond. This is an increase in your cost
basis because you paid tax on interest income which you will not receive until
maturity.
Your cost basis is the original purchase price plus the accumulated OID.
Method B. If the bond was not issued with an original discount, first determine the
original purchase price of the bond from the trade confirmation. Do not include
the accrued interest that you may have paid at the purchase date. You should
have already deducted this on your Form 1040 Schedule B as a reduction of
interest income.
Next accrete the discount from the date of purchase to the date of sale using
either the "yield to maturity" method or the "ratable accrual" method (see menu
at left for explanations.) This discount accretion should all be reported as
ordinary taxable interest income in the year of sale. Alternatively, in the year of
purchase, you could elect to report the discount accretion as additional taxable
interest income each year over the life of the bond.
Your cost basis is the original purchase price plus the accumulated discount
accretion using either the "yield to maturity" method or the "ratable accrual"
method (see menu items at left for detailed instructions on how to apply
these methods.)
See below for our interactive tool to help you calculate your cost basis using
the "yield to maturity" method.
D. If you bought a TAX-EXEMPT bond at a DISCOUNT and sold it PRIOR to maturity:
Now it gets a lot more complicated. Trust me, you want to hold your bonds to
maturity if at all possible. Not only do you avoid the cost of the sales commission
and the bid/ask dealer spread, but you can also avoid the following accounting
nightmare (unless you are truly a glutton for punishment.)
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You are required to accrete the
discount over the life of the
tax-exempt note or bond to
determine your cost basis using
the "Yield to Maturity" method. See
menu at left for an explanation
and example of how to do this.
Your cost basis is the original
purchase price plus the
accumulated discount
accretions using the
"yield to maturity" method.
| Click on the image below to
access our handy interactive
tool to calculate your cost basis
using the "yield to maturity" method.
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| Amortization Table Generator |
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